BND - XYLD: Solid Income Investment

2023-10-10 10:50:42 ET

Summary

• The Global X S&P 500 Covered Call ETF is a covered call fund focused on the S&P 500 selling at-the-money call options with a dividend yield of 11.24%.
• XYLD has outperformed bonds and cash investments, providing a stable income and growth which has outpaced inflation since inception.
• XYLD has shown to be a sustainable and reliable income investment for those living off the income.

Thesis

The Global X S&P 500 Covered Call ETF (XYLD) is an exchange-traded fund, or ETF, with a high dividend yield and inflation beating performance. XYLD may be a solid and sustainable income investment with better performance than assets like bonds and cash investments for those living off the distribution income.

Fund Strategy & Performance

XYLD is a popular covered call ETF, with $2.87B assets under management ("AUM"), the companies of the S&P500, and a monthly paying dividend with a TTM yield of 11.24%. Cousin of The Global X Russell 2000 Covered Call ETF (RYLD) and the popular The Global X NASDAQ 100 Covered Call ETF (QYLD), all employ the same at-the-money buy-write strategy :

The Global X S&P 500 Covered Call ETF ( XYLD ) follows a "covered call" or "buy-write" strategy, in which the Fund buys the stocks in the S&P 500 Index and "writes" or "sells" corresponding call options on the same index.

XYLD provides the diversity and liquidity of the S&P 500 Index, which includes the top 500 U.S. equity market companies. It employs an at-the-money (ATM) covered call strategy to generate income: selling call options ATM on a portion or all of the stocks in its portfolio. In exchange for the sale of these call options, XYLD earns premiums from the buyers and this cash settlement is used to provide dividends or distributions to the funds investors.

Usually, the fund's monthly distribution is the lesser of 1% of the NAV or 50% of the options premium. The remaining premium is reinvested back into the fund to help stabilize or increase the NAV. When the fund sells call options on its holdings, it sets a limit on the potential gains. This is because it commits to selling the underlying assets at a predetermined price if the options are exercised. This strategy represents a balance between generating income and growth potential.

Since inception in June 2013, XYLD has had a total return of 81.61% and a price return of -3.68%. It's generally important to track the price return with these types of funds since the distributions are directly correlated to the NAV.

Cash is King, XYLD is Overlord

Let's compare XYLDs performance to the largest Bond ETF: the Vanguard Total Bond Market Index Fund ETF ( BND ).

It's observed that in the last ten years, XYLD had a total return & price return of 75.55% & -6.36% vs. BND's 17.68% & -14.72% respectively. With a better price return and most importantly better total return, XYLD has clearly outperformed BND. Next, we need to take into account inflation from this time period in order to place XYLD correctly. Let's see how both these funds compare to the US dollar over the same time period:

The US Dollar had an average inflation rate of 2.80% from 2013 to 2023, XYLD had an average total return of 7.56%, and BND 1.77%. Factoring in inflation, XYLD had an average total return of 4.76% while BND had -1.03%. It's not just bonds: High Yield Savings Accounts (HYSAs), Money Markets, and CDs, though highly promoted and used to excuse investing in stocks or paying off debt this year, have historically underperformed inflation over the last 20 years from 2002-2022 as well at about -1.4% average total return at best. Compared to XYLD, a 4.76% inflation adjusted return is a solid return. XYLD has so far provided high income and enough growth to safely outpace inflation.

Risk Analysis

Future performance should consider the following risks

• Prolonged bear market
• Strategy change
• Recent inflation

Though XYLD has been through a bull market, Black Swan event (COVID-19 Crash), and bear market over the last 10 years, I think another test we need to see is a prolonged bear market. Due to the covered calls, it takes a fund like XYLD awhile to recover, the price is still recovering since the bear market ended last October. This price affects the distribution and dividend growth as mentioned earlier. It would be telling to see its performance in a 2-3 year long bear market.

All the above events should especially be considered when taking into account the fund changed its options strategy in August 2020 from a 2% Out-of-the-money (OTM) strategy to an ATM strategy in favor of higher yield, so the performance data from the last 10 years is mixed in strategy. This change maintains the same downside risk and further limits the upside potential. I split the data from October 2013-2020 when it operated at a 2% OTM strategy and October 2020-2023 where it now operates an ATM strategy:

We see that the average total returns are very similar at about 6.6%, but has had significantly more price decline in the last three years of -12.26% vs. an appreciating price return of 6.37% prior to the change. Though the fund went through the COVID crash and recent bear market which really bit at the price, such drops directly cut into the funds distributions. It would be more ideal if the price slowly rose or at least stayed flat while maintaining the high yield. I would like to see the price return eventually regain positive territory.

Last, it's important to keep in mind the more recent average inflation rate from the last three years is 5.86% which is less than 1% away from the total return you would have earned during the same time period. Though the Federal Reserve aims and manages a long-term average of around 2% inflation, persistent pressure can make XYLD's returns less useful and at risk to losing to inflation if inflation runs high for several years in a row.

Forward-Looking Sentiment

All things considered, I think XYLD is a good income investment alternative for those living off of or supplementing their lifestyle with the income. The fund beats inflation and cash investments by a decent margin, which for me is a requirement to even consider keeping in my portfolio. I would use this fund to cover part of or all of my "forever expenses" as I call them: food, taxes, insurance, energy, water, internet bills, etc. The nice part with a fund like XYLD is you need a fraction of the capital to make enough monthly income to survive if you have no debt, for me it's about $2000/month or $213,500 based off the 11.24% TTM yield vs. $600,000 using the 4% rule. From then on, I would invest in growth, dividend growth, bogle-like funds, and beyond.

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